Rising Rates: Why investors are buying into gilt funds and 10-year constant maturity gilt funds

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When interest rates go up, bond prices fall. To avoid losses, investors steer clear of mutual fund schemes investing in long-term bonds. However, the statistics for mutual fund investments in May hold a surprise. Though small, gilt schemes and gilt with 10-year constant maturity schemes, both with exposure to long-term bonds, have seen net inflows.

Despite being in a rising interest rate scenario, some investors are taking a contrarian call. Let’s see why.

Unexpected inflows

As per the monthly data released by the Association of Mutual Funds in India, Gilt funds — schemes investing in government securities — received net inflows of Rs 175 crore in May 2022. These schemes have seen net redemptions each month since December 2021. All gilt schemes put together managed Rs 15,107 crore as of May 31, 2022.

Gilt funds with 10-year constant maturity are mutual fund schemes that invest in government securities in such a manner that the average maturity stands at 10 years. These schemes received net inflows of Rs 447 crore in May and all such schemes put together manage assets worth Rs 1,565 crore.

“When the surprise rate hike on May 4 took place and the yield spiked to 7.49 percent, some traders may have found it attractive,” says Joydeep Sen, Corporate Trainer, Debt.

Also, the assets under management of the IDFC Gilt 2027 Index Fund and IDFC Gilt 2028 Index Fund put together saw an uptick of Rs 1,018 crore in May 2022, as per ACE MF data.

Why take a contrarian view?

Many times, savvy institutional investors or corporate treasuries look for less risky trades for short tenures ranging from a week to a month. They have clearly defined targets and stop loss levels. Moves such as a surprise rate hike tend to distort the market, but then the prices revert to mean and such trades pay off. Some such investors may have taken exposure through mutual funds.

Also there may be some savvy positional investors who want to invest for the medium term and may have entered this space of long-term bonds. These schemes invest in government securities that carry little credit risk and are offering relatively higher yields compared to most other fixed income options with a similar risk profile.

“Investors are going for gilt funds because they are getting a sense that the RBI will be in a difficult position to raise the rates aggressively as inflation is due to supply side factors not because of demand side factors. Also hiking rates will hamper growth and the RBI may be restricted at a certain point to raise rates,” says Deepak Panjwani, Head, Debt Markets, GEPL Capital.

Another point that makes investors think that the peak in long-term government bond yields is nearing is the large government borrowing programme. “The RBI has to explore all possible tools to keep yields low, because rising yields mean the interest bill on government borrowings will go through the roof,” says a fund manager, who is not allowed to speak to the media.

Rising rates are detrimental to these investments. Over the last 12 months (ended June 9, 2022) gilt schemes have given 0.16 percent returns and gilt schemes with 10-year constant maturity lost 3.04 percent returns, as per Value Research.

Some clarity over the future course of yields may help investors take a more informed decision.

What to expect

After hitting a low of 5.75 percent in July 2020, the yield on the 10-year benchmark bond has gone up to an attractive level in CY2022 and currently quotes around 7.5 percent. This is an outcome of the expected inflationary pressures and subsequent rate actions by the RBI.

Now, investors are worried about inflation and how long the RBI will take to tame inflation. While the central bank is acting on curbing demand by raising interest rates and sucking out liquidity, the government is actively working to address the supply side issues. Curbing exports of foodgrains by setting quotas, imposing export duties and cutting taxes on fuels are among the measures taken by the government.

“Measures already taken by the RBI and the government and the intention to take further measures would ensure containment of inflation in the next 6-12 months. This should ensure a limited upside to bond yields, as the market tends to discount the future well in advance,” says Dinesh Ahuja, Fund Manager, Fixed Income, SBI Mutual Fund.

“The bond markets have factored in the expectations of an increase in interest rates by the RBI. Going forward, long-term yields may move up less than the extent of the RBI rate hikes,” says Sen.

Panjwani expects the 10-year benchmark bond yield to move in the range of 7.25 to 7.90 percent this financial year and the RBI to hike rates by another 35 to 50 bps.

Should you invest?

For almost a decade, most fixed income investors have been focusing on short-duration products. But the situation may be changing. “Long-term bond yields have gone up over the last one year. At 7.65 to 7.75 percent yield, the benchmark 10-year bond can be a good investment for an investor with a three-year view,” says RK Gurumurthy, Head, Treasury, Dhanlaxmi Bank.

Investors looking for a high coupon and possible capital gains over the medium term are looking at investing in gilt funds and gilt funds with 10-year constant maturity schemes. If interest rates do not move up much or move sideways before coming off the peak, then these investors may make decent gains over the medium term.

Ahuja recommends staggered investments in long-duration products over the next three to four months. “They can be rewarding for investors with a minimum three-year time frame,” he says.

Gains booked on debt fund units held for more than three years are treated as long-term capital gains and are taxed at the rate of 20 percent, with indexation.

Though this may sound like a high return potential investment, do not ignore the risks. It is difficult to predict when bond yields will peak. In case there are adverse developments such as a worsening geo-political scenario, rising inflation and a massive increase in government borrowings, bond yields can go up further and in that case, investments in long-duration products will suffer.

“Retail investors need to have a long enough view while investing in duration products. If the yields go up, then the investors will see marked-to-market losses on their investments in the interim period,” warns Sen.

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